Publicly traded corporations, like FaceBook (NASDAQ:FB), Home Depot (NYSE:HD), and Wells Fargo (NYSE:WFC) are required by the SEC to submit and publish an annual report that describes their operations and financial conditions. Most of the report is management’s discussion and analysis (MD&A) chronicling the company’s activities over the past year, along with challenges and market risks. The final quarter of the report, more or less, is comprised of the audited financial statements and accompanying notes and disclosures.  The whole package usually runs around a hundred pages or so. Just for fun sometime, look up an annual report for a company you think is publicly traded, but be aware that just because a company is monolithic or iconic doesn’t mean it’s publicly traded. For instance, Fender Musical Instruments, Corp. is world famous for its guitars and is traded on the National Association of Securities Dealers Automated Quotations (NASDAQ) as FNDR, but Gibson Brands, Inc. is privately held, so there is no publicly disclosed information.

For those companies that are publicly traded, the annual report should include the following sections: Management’s Discussion and Analysis, and the audited financial statements.

Management Discussion and Analysis (unaudited)

In the Management discussion and analysis (MD&A) section of a company’s annual report, management provides an overview of the previous year’s operations and how the company performed financially. Management also discusses the upcoming year by outlining future goals and approaches to new projects.  The SEC requires an independent CPA firm perform an annual audit of a company’s financial statements, and an audit is an opinion as to whether the financials are free of material misstatement. Auditors perform test work to determine if the financial statements are materially correct, but CPAs do not audit the information in the MD&A section.

The Audited Financial Statements

The basic company financial statements included in the annual report are the balance sheet, the income statement, the statement of retained earnings, and the statement of cash flows.

Balance Sheet

Assets are what a company owns.  Equity and liabilities show who owns it.  Liabilities are debt, and equity is what is left over for the owners if all the assets and liabilities were liquidated at the amounts shown on the balance sheet.  You could imagine a simple balance sheet centered around your home or your car. Let’s say your car cost you $25,000 and you put $5,000 down and financed the rest.  A simple balance sheet would show an asset of $25,000 that was equal to (balanced by) debt of $20,000 and equity of $5,000. A business balance sheet would be more complete—in fact, one of the underlying accounting principles requires companies to show all assets and all liabilities on the balance sheet (the completeness principle.)

Income Statement

Also called the P&L for Profit and Loss, or the Statement of Earnings, the income statement shows increases and decreases in net assets from running the business.  Assets are increased by revenues and decreased by expenses. Revenues are the earnings of the business from selling goods or services, and expenses are the costs of doing business—they measure the amount of resources used up producing revenue.  In fact, the word “expense” literally means “used up,” as in, “I went to the gym and expended all my energy.” In this case, expenses are assets, mostly cash, but also equipment and other capital investments, used up in creating new wealth.

Statement of Retained Earnings

The statement of owners’ equity, also called the statement of retained earnings, reconciles the net income from the year to the balance sheet statement of equity.  In other words, if a company started with $30,000 in equity (last year’s ending equity) and made $125,000 in net income, it would then have $155,000 in equity, before any additions or withdrawals.  If the owners took out $90,000 for their own use, equity would then show on the balance sheet as $65,000 ($155,000 less $90,000.) If, in addition, the company sold stock on the open market raising $1,000,000, equity would then be $1,065,000.  All of this information and more is available on the statement of retained earnings. There is a companion statement called the statement of comprehensive income that includes such things as unrealized gains and losses on investments; however, that is beyond the scope of this overview.

Statement of Cash Flows

Finally, the audited financial statements include a reconciliation of beginning and ending cash, called the statement of cash flows.  Similar to the statement of equity, it shows the transactions that affected cash in three sections: operations, investing, and financing.  Investing includes purchasing (and selling) fixed assets. Financing includes both debt and equity sources of capital. Operations is usually represented by a reconciliation of accrual basis net income to cash basis.

Footnotes and Disclosures

In addition to the basic financial statements, companies using GAAP are required to add pages and pages of footnotes and disclosures, covering everything from the basis of accounting and the fiscal year, to how revenues are recognized, to outstanding lawsuits and other contingencies.  Some of these footnotes explain the amounts on the face of the financial statements, and some add information not apparent from the financials themselves.

The Auditor’s Reports

The SEC requires an independent CPA firm perform an annual audit of a company’s financial statements, and an audit is an opinion as to whether the financials are free of material misstatement. Auditors perform test work to determine if the financial statements are materially correct.  However, CPAs do not audit the information in the MD&A section.